Tuesday, July 3, 2007

Borrow $500,000 for only $500 a month!

I'm sure you've received these flyers in your junk mail. People call us every day asking if those letters are "for real," and if so, can we do this for them. It is for real, and we can offer it, but we probably won't, because in most cases it would be unethical to do so.

What those flyers are selling are mortgages with negative amortization, commonly called "Neg Am" or "Defferred Interest" loans. Your payment is calculated as a small percentage of the loan amount (1.25% is the most common number), much like a minimum credit card payment is calculated. And you know how you never make a dent in your credit card balance by making the minimum payment? Well with a Neg Am mortgage loan, your principle balance increases every month to encompass the interest you haven't paid.

It's starting to not look quite as good as it did on the flyer, isn't it?

To qualify for these, you generally need a 10% down payment and a high credit score. So let's do some math (sorry, it's what we do here). Here are the nuts and bolts of how you can borrow $500,000 for $500 per month.

You buy a $550,000 house with a $50,000 down payment. Your interest rate is 6.375%, but your payment rate is only 1.25% of the loan amount annually. The interest differential you're not paying is added to your loan amount each month. In less than two years, you'll owe $550,000 to the lender. And (surprise!) your payment will be adjusting to the fully amortized amount (which is $3,119.35 per month, principal & interest only).

Can't afford the new payment? You'd better hope your house increased in value enough that you can sell it for more than you now owe.

You might be wondering why these loans even exist in the first place. But they're actually a great option for a limited number of people, especially when the market is such that interest rates are decreasing and home values are increasing rapidly. The problem is they're designed to be a cash-flow mechanism for people who understand what they're doing, but they're being used as a way to "help" people buy houses they can't actually afford.

For a financially savvy person who's using that deferred interest to make money elsewhere, this can be a good option. We've also done a couple of these for people who make the bulk of their money once a year, like Christmas Tree farmers, for example. They have a nice low payment during the year to help them cash flow, and when they receive the bulk of their annual income, they pay the interest current.

So negative amortization isn't always negative, it's just not a good option for most people most of the time.

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